Portugal’s Main Energy Producer that Everyone Loved to Hate

Authors: João Carlos Marques Silva, Ph.D. and José Azevedo Pereira, Ph.D.

Index

Synopsis ...... 1 The Early Years ...... 2 The Initial Energy Subsidies ...... 2 Liberalization of the Market ...... 3 The Subsidies from 2007 onward ...... 3 CMECs under Scrutiny – the ERSE Study ...... 3 CIEG - The Biggest Subsidy that Includes the CMECs ...... 5 CIEG – Additional (hard to explain) Costs ...... 7 CMEC Compensation Scheme and Supervision ...... 7 Latest Significant Developments (2014-2017) ...... 8 Extraordinary Contribution on Energy ...... 8 Mexia’s Position in EDP to be Terminated? ...... 9 Smaller Competitors Facing Difficulties ...... 9 Special Tax on - Cracks on the Government Coalition for State Budget 2018 ..... 9 EDP’s Response to Negative Public Awareness ...... 11 ’s Credit Rating ...... 13 EDP’s Shareholders & Mindmap ...... 13 Concluding Remarks...... 15 Annex A – International Growth of EDP ...... i Annex B - Financial Data and KPIs ...... ii EDP’s Financial Statements ...... ii EDP’s Financial KPIs ...... vi EDP’s Share Value Over Time ...... viii Market Discount Rates in 2007 ...... ix Discount Rates for Electricity Utilities ...... ix Annex C – China Three Gorges Corporation ...... x Company Profile ...... x Purchase of EDP ...... x Annex D – Portugal / China Relationships in 2017...... xii Annex E – CIEG Components Explained ...... xiii Annex F – Guiding Case Questions ...... xv Annex G - About the authors ...... xvi References ...... xvii

Portugal’s Main Energy Producer that Everyone Loved to Hate

Synopsis This business case portrays the problems that an energy producing company faced in Portugal, in its transition from being a public company to becoming privatized. The Portuguese Government issued EDP with generous subsidies to guarantee its future profits and privatization success, but a few years later, after EDP was fully privatized, there was great political pressure to downsize such subsidies.

The case describes the main steps taken by EDP from its creation and privatization, culminating at the end of 2017, where it was heavily criticized by media and political parties due to high value of subsidies that had been granted to the company by the Portuguese Government in the past, while it was still a public company, and the renegotiation of those same subsidies after it had been privatized. EDP’s president António Mexia was under police investigation due to having led the renegotiation talks in 2007, and it was feared that EDP’s investors could refrain from investing in the company.

Should EDP campaign to clear its good name, or would it be better to let the matter fall with the passing of time? Could the share value be affected? Should EDP prepare itself for loss of revenue due to an eventual downsizing of the subsidies?

Keywords: energy sector, subsidies, privatization

1/15 The Early Years EDP was created in 1976, after the merger of 13 companies that had been nationalized the previous year, becoming Portugal’s (only) electricity provider. The name stood for “Electricidade de Portugal” (Electricity of Portugal). As a state company, it was responsible for providing electricity for the whole country, the modernization and extension of the power distribution lines, planning and construction of the national electricity-producing park, and of designing a unique tariff for all its clients.

In the mid 1980’s, EDP’s power distribution covered 97% of continental Portugal and assured 80% of the country with low voltage electricity. In 1991, the Portuguese Government decided to change EDP’s juridical stature from a private company to an Anonymous Society (Sociedade Anónima – SA). In 1994, after a profound restructuring (from which REN (Redes Energéticas Nacionais1) emerged), the EDP group was created.

The Initial Energy Subsidies In 1995, the CAE (Contratos de Aquisição de Energia / Power Purchase Agreements) were celebrated between the Portuguese Government (via RNT – Rede Nacional de Transporte / Nacional Transport Network) and all power producers, in order to guarantee controlled energy prices for Portugal and prepare EDP’s privatization, guaranteeing most of the company’s future profits. The long term CAEs (about 30 years) would guarantee that EDP’s power plants would sell the totality of their produced electricity at fixed prices (according to technical and commercial conditions defined in the contract) to the concession entity of RNT, therefore guaranteeing future cash flows without any market risk. Tariffs to the public service system’s (SEP – Sistema Eléctrico de Serviço Público) end customers (and also for the transmission and distribution parts) were regulated by ERSE (Entidade Reguladora dos Serviços Energéticos), the Portuguese Electricity Regulatory Agency.

In June 1997, EDP enters its first privatization phase, selling off 30% of its capital. It was an operation of great success, in which demand was 30x in excess of the supply, turning over 800 thousand Portuguese (about 8% of the population) into new EDP’s shareholders. Additional privatization phases occurred in May 1998, June 1998, October 2000, November 2004 and December 2005. In 2013, the Government’s last 4,144% of the capital was sold (at 2,35€/share), forfeiting the totality of public presence in EDP’s equity.

In November 2000, REN left the EDP group, in compliance with the directive 96/92/CE of 19 December 1996, that imposed a legal separation between companies responsible for the management of the power distribution network and companies responsible for the production and distribution of electricity.

In 2004, and in order to comply with the European Commission’s directive to promote free competition (directive 2003/54/CE) in the Iberian energy market (MIBEL), the CAE was to be abolished for the majority of the power providers.

1 Originally REN was dubbed as “Rede Eléctrica Nacional” (National Electric Grid), but later its name was changed to Redes Energéticas Nacionais (National Energy Grids). Nowadays (after 2006), we can say that REN operates the RNT (Rede Nacional de Transporte – Nacional Transport Network).

2/15 Meanwhile, it was in 2005 that António Mexia started his role as the president of EDP, replacing the former president João Talone. Before that, he had been a executive member in the Administration board of Banco Espírito Santo (1992-1998), and progressed to vice-president of the Administration Board (2000-2001). In , he had been President of the Executive Committee (2001-2004) alongside being president of the Administration board of Gás de Portugal, Transgás and Transgás Atlântico. To finalize, between 2004-2005, he was appointed as the minister of the Public Works in the Government headed by Pedro Santana Lopes2.

Liberalization of the Market The Portuguese energy market was liberalized in 2006, and many suppliers started operating in Portugal. The clients had to choose their supplier; they were automatically transferred to EDP-SU (Universal Service), which had a regulated (and higher) tariff than the free competition, before choosing their new supplier – most customers simply moved to EDP Comercial, mostly using a streamlined procedure that could be completed over the phone without any formal signature (the customers were effectively staying in the same company), and had substantially lower prices than the EDP-SU, while the new competitors required a signed contract and information about the current energy conditions (and had marginally lower prices than EDP Comercial). The liberalization of the market dictated that all energy producers should be in open competition, dictating the end of the CAE (though in reality it wasn’t as simple as that, as briefly explained a bit further down).

The Subsidies from 2007 onward The end of the CAE was negotiated only to give rise to the CMECs (Custos para a Manutenção do Equilíbrio Contratual / Costs for the Maintenance of Contractual Equilibrium) [Observador 2017A]. The CMECs were effective from July 2007 onwards (based on reference market megawatt hour rates for the corresponding years, having the original 2004 market parameters updated), and basically served as a compensation for the end of the CAE3. The European Commission approved the CMEC (reluctantly), as long as the total payments throughout the CMEC’s lifetime didn’t exceed a maximum of 5.5M€. CMECs were to be financed by the energy tariff charged to end users, based on an overall revised estimation each year.

In 2007, the Portuguese Government also negotiated an extension to the lease of 27 powerplants, with EDP paying 759M€. Another concession that was very controversial was the license to explore the coal power plant ad eternum, that was given to EDP without any state compensation. CMECs under Scrutiny – the ERSE Study The way that the CMECs’ market parameters were redefined in 2007 was scrutinized by the European Commission, in 2012, as the result of an official complaint. However, the Commission dismissed it, stating that the same fundamentals discussed in 2004 prevailed (namely, the Commission didn’t classify the CMEC as being a case of state help). The lease extension of the 27 power plants were also subject to a complaint by violation of the free competition (no public contest was held for the new

2 This was the XVI Constitutional , and was appointed by Portugal’s president after the resignation of the former prime-minister Durão Barroso, who went on to be president of the European Commission (2004-2014) 3 “Turbogás” and “Central do Pego”, two power providers outside of the EDP group, opted to remain with the CAE (this generated some controversy; but it seemed that legally the providers could opt to remain within the CAE). The EDP group complied to the CMECs for political purposes, and ensured that the CMEC’s calculations were “financially equivalent” to the CAE.

3/15 leases of the power plants, for instance), but the European Commission also dismissed it after an investigation of their own, stating that the values involved were according to market conditions.

Nonetheless, and also due to complaints made in 2012, the Portuguese Public Ministry was also investigating both cases alongside the Sines coal power plant adjudication, having raided EDP, REN and the consulting firm Boston Consulting Group in June 2017, to investigate eventual passive and active claims [Observador 2017B]. In all, it was believed that the total excessive benefit to EDP was over 1.000M€, 510M€ from the CMECs and the rest from the licensing deals. Despite all this, EDP’s shares outlook remained favourable [Dinheiro 2016].

In 2012, the university of Cambridge published its study on the CMEC’s profitability, and estimated the CMEC’s effective profitability to be 14,2%; significantly above the WACC of 7,55% used to set the CMEC’s standards. EDP’s CEO, António Mexia readily dismissed the results, accusing the study of bearing gross and basic mistakes.

In March 2012, the Secretary of State for Energy Henrique Gomes resigned from the government, allegedly due to pressure from the energy lobby, which was exerted after the drafting of a report intended to apply excessive rent cuts in the Portuguese electricity sector, particularly EDP, in the amount of EUR 165 million per year. These policies were set out in the Memorandum of Economic and Financial Policies concluded in May 2011, but they were never put into practice; in [Negócios 2013], this situation is described in further detail.

From 2007 to 2017, about 2.500M€ were paid to EDP via the CMECs (a mean of 250M€/year). In 2017, the Portuguese Government expected an analysis report from ERSE to calculate and justify the excessive value paid to EDP, and somehow charge EDP for such amount. In [Esquerda 2016], it is explained that about 33,3% of EDP’s profits before taxes came from CMECs, between 2009 and 2012, and elevates the mean of 250M€/year to 370M€/year in more recent years.

The ERSE study on the CMEC revealed that EDP should be paid 154 million €/year between 2017 and 2027 – a value substantially different than the 256 million € that resulted from a similar study made by EDP and REN. ERSE also stated that EDP was overpaid by 510 million€ in the CMEC contracts between 2007 and 2017 (as previously mentioned). EDP demanded that the study was made available for its analysis, but their request was denied until (according to ERSE) “the Government made their own adjustments to the CMEC” based on the study and its recommendations. EDP was given a report with the study’s summary and main results, but even so opted to put ERSE on trial in order to make the whole study document available. EDP also volunteered to aid with validating (and correcting) the numbers [Observador 2017C].

This happened at the same time that EDP was under scrutiny after suspicions of instructing the Portuguese Government on how to write the legislation concerning the CMEC. The suspicions stemmed from the content of some emails exchanged between EDP’s president António Mexia, EDP’s board member João Manso Neto and the former minister of Economy and members from his cabinet, who served under the Government of PS – the political party in power at the time - led by José Sócrates (the former prime minister that was already arrested on corruption charges). EDP’s comment on the matter was that there was a strong collaborative relationship with the Government, and that such relationship also included “aiding the Government in taking the best decisions on the energy sector” [Observador 2017D].

4/15 CIEG - The Biggest Subsidy that Includes the CMECs The ’s electric tariff is also analysed in detail in [Esquerda 2016], and, as a result of such study, it was seen that 33,3% of the tariff wasrelated to the CIEG (Custos de Interesse Económico Geral – Costs of General Economic Interest). These costs not only financed the CMECs (about 17% of the CIEG), but also renewable energy (66,7% of the CIEG); meaning that the main subsidizing cost paid by the population weren’t the (much discussed) CMECs, but the renewable energy cost, weighing about four times as much as the CMECs! Nearly all production in the “special regime” (renewable energy such as wind energy, cogeneration, solar, biomass, mini-hidric) had their sale guaranteed, since it first entered in the network for usage. The producers of renewable energy were assured a steady tariff without any market competition, higher than those produced in power plants, for a period between 15 to 20 years, so that the initial investment was totally recovered, including interest. In 2016, the added costs for such power amounted to 1250M€, 2/3 of the CIEG.

13% Special Regime Producers (PRE) 9% CMEC

11% CAE 67% Concessions to counties

Figure 1 – Breakdown of CIEG costs in the Portuguese Electrical Sector for 2016 (source: ERSE)

There was much talk about these “excessive rents” as well, and they were to be taken as something that the Portuguese Government could try to renegotiate in the near future. From Figure 2, we can see that prices in the EDP renewable company was much higher for Portugal than in the rest of the world; with only 7% production in Portugal, EDP renewables had 21% of its profits from its operations in Portugal, clearly signalling that prices were overly estimated.

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Figure 2 – EDP Renováveis’ statistics

Another worry from the Portuguese Government was the Public Energy Tariff Debt (Figure 3). In 2008, the Portuguese Government invoked social worries, and postponed the billing to consumers of a substantial part of the CIEG. This led to a Public Energy Tariff Debt to be collected later, with interest rates ranging from 2% to 6%, depending on the years. EDP readily transformed this into a new business and sold great part of this debt to international funds. The debt has been increasing due to further postponements of payments from the Government, in order to “protect” the consumers, rapidly reaching over 5.000M€.

Figure 3 – Evolution of the Public Energy Tariff Debt

6/15 CIEG – Additional (hard to explain) Costs Additional superfluous costs also persisted for the “resource availability for exceptional needs”, also dubbed as the “excess power guarantee”. From the supplier side, power plants from EDP and Endesa had “standby” states in case of need (which is rarely used), costing the end consumer 33M€/year in the CIEG – there were forces within the Portuguese Government that wanted to change this situation, wanting only to pay for the excess capacity in case of need (and not has a fixed contracted value, whether there is need or not) , and by auction, in the future.

Another service that was also charged to end consumers was on the demand side, namely with industrial units that consumed high amounts of energy. These units (about 50 in total) received part of the CIEG to reduce their energy intake in case of need. Per REN, this service was never used, since the excess power guarantee was already provided by the power plants; however, the value of this service had been increasing, reaching 110M€ in 2015 (it was 55M€ in 2011), as shown in Figure 4.

Figure 4 – Costs of the readiness to reduce power consumption

CMEC Compensation Scheme and Supervision

The CMEC’s formula to calculate the differential paid to EDP consisted of 2 types of remuneration; a fixed parcel and a variable parcel. The variable parcel had 3 essential components; namely an adjustment linked to the power plant’s availability, an adjustment linked to the market’s gross margins and a final component linked to the system services’ revenues. This final parcel (system services)

7/15 allowed for the power plant to offer its capacity to fill in gaps between offer and demand, offsetting any imbalances.

EDP had power plants with guaranteed revenues by CMECs and power plants that sold their energy in the wholesale market, at a variable cost (without any CMEC compensation). In 2014, the AdC (Autoridade da Concorrência) studied how the CMEC was being applied and reached the conclusion that there was some overcompensation to EDP due to the system services being provided mainly by the power plants outside the CMEC deal (hence increasing EDP’s profits, that controlled 90% of the system service market, since the CMEC power plants had guaranteed revenues). This led the AdC (Autoridade da Concorrência) to warrant mechanisms alongside ERSE to check that producers with CMEC contracts did not use their power plants without CMEC contracts for the system services, maximizing their revenue at the consumer’s expense. One of the figures from AdC’s study is portrayed in Figure 5.

Figure 5 – Power plant production for system services (source: REN)

Looking at Figure 5, we can see that the EDP CMEC power plants contributed a lot less for the system services than the free market power plants. Through statement nº 4694/2014, ERSE changed a few mechanisms in the CMEC in order to promote a more efficient use of CMEC power plants, and save between 25M€-30M€/year, according to [Observador 2016].

Latest Significant Developments (2014-2017)

Extraordinary Contribution on Energy In 2014, the Extraordinary Contribution on Energy (CESE) was created; a time in which all sectors of the Portuguese society were cutting costs. CESE had as a goal to support the Fund for Systematic Sustainability of the Energy Sector (FSSSE) [PLMJ 2014]. The FSSSE aimed to ensure the creation of mechanisms for sustainability of the energy sector, which included the reduction of the tariff debt and the financing of social policies and environmental aspects of the energy sector, implementation of efficiency measures, support measures to companies and minimizing costs for the National Electric System through the CIEGs. The CESE was calculated as 0,85% over the liquid assets of the companies.

8/15 Between 2014 and 2016, EDP paid 180 M€ for the CESE (a mean of 60 M€ per year), and was estimated to pay around 55 M€ in 2017 and 2018 (due to the depreciation of assets).

At the end of 2017, EDP decided to contest the payment of the CESE, taking the case the court; something that GALP did from the instatement of the CESE. At a time in which the Portuguese Government wanted to implement a new tax to be applied on the producers of renewable energy, this seemed like an extra argument for a big fight [Observador 2018].

Mexia’s Position in EDP to be Terminated? António Mexia was in a delicate position in EDP, since CTG (China Three Gorges, EDP’s biggest shareholder, owned in full by the People’s Republic of China) wanted to see him replaced before the general shareholder meeting scheduled for April 2018 [JN 2017]. This was mainly due to the fact that Mexia was made a suspect on the investigation of the CMEC negotiation undertaken by the judiciary police, facing charges of corruption. CTG was worried that Mexia’s position could seriously weaken the relationship between EDP and the Portuguese Government, specially at a time where the CMEC values were under discussion, and there were significant forces on the Portuguese Parliament wanting to lower the CMEC values significantly. Another speculated topic that could undermine Mexia was the possible merger with Gas Natural Fenosa, to which CTG was opposed to. Smaller Competitors Facing Difficulties By November 2017, EDP’s smaller competitors were facing serious difficulties due to the drought that the Iberian Peninsula was facing, raising the energy retail price significantly since October 2016 [Expresso 2017]. ERSE was transferring the clients of the bankrupt energy operators (that failed on their payments to the network access fees) to EDP-SU (Universal Service), that was obliged to accept all customers that the market didn’t want or couldn’t supply, at least until those customers found a new supplier.

Besides the rise of the energy prices due to the drought, the smaller suppliers also had some treasury issues that hindered their operations; the energy suppliers had to pay network access fees to EDP Distribution in 17 days, but would only be paid by their clients after 30 to 60 days. Adding to this, EDP Distribuição also demanded financial guarantees equivalent to 45 days of network access fees, requiring the smaller companies to having large amounts of working capital (that most would obtain through short term credit lines).

By the end of 2017, the Portuguese free electricity market had 4,85 million clients (the regulated market had 1,3 million). 97% of the free market clients belonged to the greatest electrical companies; EDP had a quota of 84,3%, Galp 5,5%, Endesa 4%, Iberdrola 2,2% and Gás Natural Fenosa 0,7%. The remaining 4,2% were at the hands of recent supplier companies of the energy marrket; Goldenergy with 2%, Energia Simples with 0,4% and other operators with 0,8%. Regarding the provided energy volume (May 2017 values), EDP had a quota of 44,2%, Endesa 18,1%, Iberdrola 16,1% and Galp 8,2% (just to cite the largest suppliers).

Special Tax on Renewable Energy - Cracks on the Government Coalition for State Budget 2018 The Portuguese State Budget negotiation for 2018 had a crucial point involving a tax to be applied on the producers of renewable energy (the PRE portion of the CIEG). The political party BE (Bloco de Esquerda - Left-wing party) defended the creation of a tax in order to pay off the debt of the Public

9/15 Energy Tariff Debt, to be collected from all energy producers under special regime, namely with a guaranteed remuneration from the 1st January 2018. This special tax had been agreed between BE and PS (Socialist Party that governed with parliamentary support from other parties, being BE one of those parties), but PS went back on their word at the time of voting (actually, they first voted favourably and then asked for a revote, changing their vote to a negative one), causing some serious cracks and accusations from their governing allies [Dinheiro 2018]. The State Budget was still approved by the governmental forces, but serious wounds were created, with accusations of lobbying, corruption and claims that PS was governed by powerful CEOs from some companies, and not their ministers and politian’s. The tax (30% of the overcost compared to market prices) was projected to yield a yearly revenue of about 250 million €, and its dismissal was seen by commentators as the beginning of the end of the governing coalition. Five large companies accounted for 68% of installed wind capacity at the end of 2016 and, according to the newspaper Expresso's accounts, these five companies had a profit of € 167 million in the referred year. EDP Renováveis Portugal led (€ 60 million), followed by Iberwind (€ 43 million), Generg (€ 32 million), Finerge (€ 21 million) and Trustwind (€ 12 million). The main official reason for backing out of this proposal was a warning that the banks that financed these projects could be affected by possible bankruptcies from the eolic companies, that could go from having a profit to facing a bankruptcy scenario [Expresso 2017B].

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EDP’s Response to Negative Public Awareness

In December 2017, EDP’s chairman Eduardo Catroga wrote an article aimed to mitigate the current state of mind and opinions, where EDP was being targeted as a greedy and morally corrupt company. The article [Catroga 2017], (whose translated title is – “questions and myths on the electric sector”) addressed the electrical sector In Portugal, Europe and the US, and aimed to explain and clarify most of the issues that were being addressed at the time, with the electrical companies (with EDP at the helm) being under heavy attack due to high energy prices.

According to Catroga, the energy sector in Portugal actually received less on renewable energy (eolic and solar, excluding hydric energy) subsidies than the European average; countries such as Italy, Czech Republic and Germany were the ones with the greatest values. Even though both eolic and solar energy production had been reducing costs throughout the years due to advancements in technology, the energy sector still required predictability in selling prices of those renewable energy sources, since the wholesale market in the Iberian Peninsula was very volatile and prices varied with the passing of every hour, mainly dictated by the variable costs of coal and natural gas power plants - this is something that the renewable power plants have no control on. Another matter of concern was that, as the mix of renewable energy increased, there was an ongoing pressure to sink the wholesale prices, since the variable costs of those technologies were virtually non-existent – in order to control this spiral recession, a wide number of countries had been predetermining the value of renewable energy through auctions, with agreed prices for the forthcoming 15-20 years. This predictability allowed to reduce the companies’ cost of capital, benefitting the final consumer.

The next figure (Figure 6) presents the result of an analysis on the weighted average cost of capital for investment in onshore eolic (2015). The main factors contributing to the WACC were the country’s risk4, and the associated risk to each country’s regulatory policies. It was also noted in this study (uncited in Catroga’s article) that the WACC in each country could lower as much as 15% if all countries had an optimum risk level.

4 remember that Portugal went through a major financial between 2010-2014

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Figure 6 – WACC across the EU28, for onshore wind

In the matter of the so called “excessive energy rents”, Catroga explained the origin of the CAE and CMECs. He explained that EDP only accepted the conversion of CAEs to CMECs due to the 5th phase of privatization, having mentioned in the prospect at the time that it would only accept the transition CAE-CMEC if the solution was “economically neutral and equivalent”, while at the same time, “certified by independent entities”. Another aspect that was discussed in the article was the concession extension of the hydric plants in 2007 – according to Catroga, the rights to explore the hydric power plants were awarded to EDP in exchange for the non-payment to EDP of the compensation rights it would have, should it stop its operations on the referred plants. The residual value of the power plants that the Government would have to pay EDP compensated for the concession extensions – the calculations were performed with the aid of financially independent entities.

To finalize, the article also refers the fact that the Portuguese Government was EDP’s main shareholder, and that it benefitted dearly in 8 privatization phases of EDP between 1997 and 2011, making a total of 10.000 M€ (without interest or capital gains).

The total public offerings and estimated benefits from the CAE / CMECs is summarized in Table 1. As a relevant fact, the Government sold its CAE-CMEC rights in every privatization phase, having an additional mean profit of 37% in due to them.

To finalize, the article still refers that the extraordinary revenues received by the Government from the electrical sector weren’t all used to benefit the consumer’s tariffs; only a small part of the extension rights paid by EDP for its use of the hydric power plants was used to reduce the energetic deficit bill; the revenues from the concessions of new hydric power plants (in which the Government gained several hundred million euros) didn’t benefit the end consumer; and only 1/3 of the CESE was being used to reduce the tariff deficit.

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Table 1 – EDP’s Public offering and benefits from CAE / CMECs

Year Offering (Billion €) Benefits CAE/CMEC 1997 2 48% CAE 1998 2,4 48% CAE 2000 1,9 48% CAE 2004 0,5 44% CAE 2012 2,7 14% CMEC 2013 0,4 14% CMEC

Portugal’s Credit Rating Portugal’s credit rating was considered “junk” (non-investment grade) since 2012 by all major credit agencies except the Canadian DBRS (a credit agency recognized by the European Central Bank – ECB), a fact that allowed Portugal to borrow money from the markets. In 2017, Standard & Poor’s was the first rating agency out of the big 3 (S&P, Moody’s and Fitch) to raise Portugal’s rating to investment grade BBB-, with a stable outlook [Observador 2017E]. S&P’s main ideas in its report were:

 “S&P estimates GDP growth of more than 2% on average between 2017 and 2020, compared with the 1.5% previously forecast”.  “There is no doubt in S&P's mind that the deficit target of 1.5% will be reached this year” (2017). “If this is confirmed, this will put the debt/GDP ratio on a firm downward trajectory.”  “The risks of a significant deterioration in external financing conditions have declined", adding that "the ECB will ensure a smooth transition towards a less expansionary monetary policy."

In 2016, Portugal had a non-investment grade with a positive outlook (meaning its grade could become positive soon) given by Fitch, but the outlook was downgraded to “stable” when the Portuguese Government had difficult budget negotiations with the European Commission, which also threatened Portugal’s only positive rating at the time, given by DBRS.

In the mid December 2017, Fitch joined S&P in attributing Portugal with a similar BBB- (in Fitch’s case, Portugal’s rating was upgrade by 2 positions) with a stable outlook. At the end of 2017, only Moody’s kept the Portuguese rating sub.grade (Ba1), but with a positive outlook. The high energetic bill that was charged to the Portuguese customers was one of the factors that contributed against economic growth, and was monitored closely by these agencies.

EDP’s Shareholders & Mindmap

An adjusted shareholder stake map is drawn here (taking into account CTG’s purchase of 1,91% of EDP in 2017). Notice that CTG was by far the largest shareholder, followed by Capital Group Companies, that had about only half of CTG’s shares.

13/15 EDP's Shareholder Stakes

23,26% 33,23%

3,02%

0,59% 12,00%

2,00% 7,19% 2,56% 2,27%

2,38% 2,44% 4,06% 5,00%

China Three Gorges CNIC Co., Ltd Capital Group Companies, Inc. Oppidum Capital, S.L. BlackRock, Inc. Mubadala Investment Company Group BCP + BCP Pension Fund Sonatrach Qatar Investment Authority Norges Bank State Street Bank and Trust Company EDP (Own shares) Remaining Shareholders

Figure 7 – EDP’s Shareholder’s position at the end of 2017

The following figure presents the case’s mindmap of the involved players and items. Note that all items and players should be referred to in the meeting to be prepared.

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Figure 8 – Case’s Mindmap of the involved players and items

Concluding Remarks

With the Portuguese political situation at hand, alongside EDP’s financial statements (in Annex B), it would be wise to present the shareholders with a best-case and worst-case scenario, in the matter of the financial impact that would come with the withdrawel of subsidies / creation of new energy taxes (although all these things could and would certainly be contested in court). EDP’s outlook in Portugal and international markets should also be discussed, in order to offset possible losses with future gains.

15/15 Annex A – International Growth of EDP

EDP grew outside Portugal’s borders and took its first international steps in 1996, with big investments in Brasil. In 2007, the EDP group, through its holding “Energias Renováveis” acquired one of the biggest wind-energy producers of the world, the Horizon Wind Energy, with generators in New York, Iowa, Pennsylvania, Washington and Oklahoma, and with projects for Minnesota, Oregon, Texas and Illinois. This made EDP the third biggest player in the wind-energy area, at the end of 2009.

In 20175, EDP was the largest generator, distributor and supplier of electricity in Portugal, the third largest company in the Iberian Peninsula and one of the largest gas distributors in the Iberian Peninsula. EDP was also one of the largest wind power operator worldwide with windfarms for energy generation in the Iberian Peninsula, the , Canada, , France, Belgium, Italy, Poland, Romania and Mexico, and is developing wind projects in the United Kingdom. Additionally, EDP generated solar photovoltaic energy in Portugal, Romania and the United States. In Brazil, EDP was the 5th largest private operator in electricity generation, had 2 electricity distribution concessions and was the 4th largest private supplier in the liberalized market.

EDP had a relevant presence in the world energy landscape, being present in 14 countries, with 9,8 million electricity consumers, 1,5 million gas customers and more than 12 thousand employees around the world. On December 31, 2016, EDP had an installed capacity of 25 GW and generated 70 TWh during 2016, of which 65% from renewable sources.

5 Adapted from EDP’s 2016 annual report.

i/XVIII Annex B - Financial Data and KPIs This section introduces some market data indispensable for valuation and competitive analysis purposes. EDP’s Financial Statements The following statements describe EDP’s financial health between 2015 and 2016. The tax expense (excluding deferred tax assets) was of 29,5%, which was made up of statutory corporate income tax rate applicable in Portugal (21%), municipal surcharge (1.5%) and the state surcharge (7%). The CESE was dependent on asset valuation.

Table 2 – Consolidated Income statement for EDP, as at 31 December 2016 and 2015

ii/XVIII Table 3 –Consolidated Statement of Financial Position as at 31 December 2016 and 2015

iii/XVIII Table 4 – Consolidated and Company Statement of Cash Flows as at 31 December 2016 and 2015

iv/XVIII Table 5 – Company Statement of Financial Position as at 31 December 2016 and 2015

v/XVIII Table 6 – Non-Current Debtors and other other assets from commercial activities as at 31 December 2016 and 2015

Table 7 – Current Debtors and other other assets from commercial activities as at 31 December 2016 and 2015

EDP’s Financial KPIs

The main financial KPIs are depicted in this section

Table 8 – EDP’s yearly profit evolution

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Table 9 – EDP’s yearly net investment and debt

Next we will portray EDP’s sustainability index, which is based on an analysis of corporate economic, environmental and social performance, assessing issues such as corporate governance, risk management, branding, climate change mitigation, supply chain standards and labor practices. The trend is to reject companies that do not operate in a sustainable and ethical manner. It includes general as well as industry-specific sustainability criteria for each of the 58 sectors defined according to the Industry Classification Benchmark (ICB). The Economic, Environmental and Social Dimension all account for 33% each to the index, where we notice that EDP is steady above 100 overall for both year, despite a slight drop from 2015 to 2016.

Table 10 – EDP’s yearly evolution of sustainability index

In

Table 11 we see the evolution of the Economic Value Generated (EVG). Note that EVG=Turnover + Other Operating Income + gains/losses with the sale of financial assets + financial income + share of profit in associates. The EVG is portrayed as the sum of the Economic Value Distributed (EVD) and the

vii/XVIII Economic Value Accumulated (EVA). We have that EVD= Cost of Sales + Operating Expenses + Other Operating Expenes + Current Tax + Financial Expenses + Dividend Payment

Table 11 – EDP’s yearly evolution of economic value generated (€M)

EDP’s Share Value Over Time

In the following figure we can see EDP’s share value over time, until the end of 2017, closing at 2,88€. EDP’s market cap was roughly 10,4 B€.

Figure 9 – EDP’s Share Value Over Time (in €)

viii/XVIII Market Discount Rates in 2007

Below are the reference average market discount rates in Europe, for all sectors.

Table 12 – European Reference Discount Rates

Discount Rates for Electricity Utilities6

Electricity utilities usually are regulated monopolies, particularly in developing economies. They have well-defined markets and also established technologies; correspondingly, they have a lower discount rate, a lower beta than the average equity. Electricity utilities, because of their secure market and established consumer base, have less risk than the market average. This has also allowed them to borrow at lower rates, thus reducing the burden on their consumers. To allow for expansion, their borrowing requirements are at least twice their depreciation allocation. It has also to be realized that the discount rate for such projects can be reduced by capital structuring and allocating risk. Although return on equities fluctuates in the stock market, recently the equity risk for electricity utilities had a mean of 5.75%, in mature markets [Damodaran 2014] .

In the case of nuclear generation (to set an upper limit), the risk in investment, execution times, financing costs and regulations are considerable. They would not be carried by a market investor in the OECD without firm guarantees and subsides, which are becoming scarce. An important factor behind these high estimated costs to build nuclear reactors is the delay that these projects often face during licensing and construction that increases the capital burden, often at high interest rates. This is also a reason why the economics of nuclear power may be more favorable in countries such as Russia, China, UAE and South Korea where projects tend to stay on schedule. A recent MIT study recommended that the discount rate for new nuclear projects should be as high as 11.5% [MIT 2003] .

6 Adapted from [Khatib 2014]

ix/XVIII Annex C – China Three Gorges Corporation

Company Profile7

China Three Gorges Corporation (CTG), the biggest shareholder of EDP at the end of 2017, was a clean energy group focusing on large-scale hydropower development and operation, and they believed to be the largest hydropower enterprise in the world in terms of installed capacity. Complementing their global leadership in hydropower, they also engaged in renewable energy businesses including wind power and solar power, and operated an international investment business in the hydropower and renewable energy sectors and international contracting business. Their total assets as of December 31, 2014 were RMB475.5 billion (RMB is the Chinese Renminbi yuan, which equalled 0,127€ at the end of 2017), and their revenue for 2014 was RMB63.0 billion.

CTG was mandated by the PRC Government to develop the hydropower resources of the Yangtze River and its tributaries. CTG has managed the development and operation of the Three Gorges Project, which is currently the largest hydropower project in the world in terms of installed capacity. The company has also been mandated by the PRC Government to develop four major Jinsha River hydropower projects: the Xiluodu Project, the Xiangjiaba Project, the Baihetan Project and the Wudongde Project. The Xiluodu Project and the Xiangjiaba Project each commenced full operation in 2014 and are currently the third largest and the seventh largest hydropower projects in operation in the world in terms of installed capacity, respectively. CTG has also commenced preparation work for the Baihetan Project and the Wudongde Project, which, once completed, are expected to rank amongst the 12 largest hydropower projects in operation, under construction and under development in the world in terms of installed capacity. Building on their clean energy expertise as the world’s largest hydropower developer and operator, they are diversifying their clean energy business by actively developing wind power, solar power and other renewable energy. Consistent with CTG’s leadership role in the global hydropower industry, they have accelerated their overseas business expansion to developed countries in Europe and North America, emerging markets with abundant resources such as Brazil and , and neighbouring countries such as Pakistan. CTG believed that their strengths in branding, technology and financing and their expertise in the full industry value chain, including design, construction and operation, were the key enablers that would drive their growth as it became a first-tier international clean energy group. Purchase of EDP CTG purchased 21,35% of EDP (representing 780.633.782 shares) for 2,69 B€ (2 690M€), after presenting the best financial proposal for such slice, at the end of 2011 [DN 2011]. The deal also contemplated a financial line of 4 B€ and the purchase of minority participations in eolic parks in the value of 2 B€. Further, in October 2017, CTG purchased an additional 1,91% for 208 M€ (2,96€/share), raising their stake in EDP to 23,26%. This later purchase occurred after rumours of a possible fusion with the Spanish Natural Gas company Fenosa [Expresso 2017], which was blocked by CTG.

The purchase was made through the society China Three Gorges (Europe) S.A., that was totally owned by China three Gorges (Hong Kong) Co. Ltd., which in turn was held in full by CWE Investment Co. Ltd.

7 adapted from www.ctgpc.com, corporation profile

x/XVIII To top it off, CWE Investment Co. Ltd was held in full by the People’s Republic of China, meaning that the Chinese Government controlled a significant part of the energy production in Portugal.

xi/XVIII Annex D – Portugal / China Relationships in 2017 China’s relations with Portugal were “in the best period of their history” in June 2017, according to Ambassador Cai Run speaking at the Business Opportunities Forum between Portugal, China and , organised by the Macau Institute for Trade and Investment the Promotion (IPIM), the China Council for Promotion of International Trade (CCPIT) and the Portuguese Agency for Foreign Investment and Trade (AICEP).

Cai Run said that the current historic period in bilateral relations was based on high-level bilateral contacts, mutual political trust, “pragmatic and fruitful” cooperation, “close communication and coordination in key international and regional affairs,” as well as contact between the people of the two countries.

The results were felt at a trade level, with two-way exchanges amounting to 5.8 billion euros, 29% more than in the same period of 2016, and with China’s total investment in Portugal exceeding 6 billion euros by the end of 2016, a flow that “grew steadily” and would benefit from the direct air link between Beijing and , which started in the summer of 2017.

The recent Forum on the Belt and Road initiative8, Cai Run said, “defined directions and identified projects to be implemented” and, since Portugal was responsible for the “page of the great maritime era,” it was an “important partner” in the initiative. Kang Wen, director-general of the Ministry of Commerce of China for Taiwan, Hong Kong and Macau Affairs, told about 200 business people about the “enthusiasm” felt for the initiative, which was “opened to all,” offering “great benefits” through concerted interests and cooperation.

Zhang Wei, the vice-president of the CCPIT, also stressed the importance of the “Belt and Road” initiative and the opportunities it provides, particularly in tourism to Portugal, given that China would soon have 700 million tourists taking foreign holidays.

António Silva, a member of AICEP, said he wanted to “encourage Portuguese companies to establish partnerships with Chinese companies,” pointing to potential sectors such as transport, specifically the port of Sines, but also renewable energy, the economy of the sea and innovation.

According to Jorge Costa Oliveira, the Portuguese secretary of state for internationalisation, there was “enormous potential in terms of tripartite business cooperation, especially in other geographies,” particularly in Europe, Latin America or Africa, where Portugal had important political relationships.

As for Macau, IPIM President Jackson Chang said he was “actively working on the implementation of various types of support,” such as the financial services platform and the renminbi clearing-house for Portuguese-speaking countries, which highlighted the territory’s role as a platform (adapted from [Macauhub 2017]).

8 The Silk Road Economic Belt and the 21st-century Maritime Silk Road, better known as the One Belt and One Road Initiative (OBOR), The Belt and Road (B&R) and The Belt and Road Initiative (BRI) is a development strategy proposed by China's president Xi Jinping that focuses on connectivity and cooperation between Eurasian countries, primarily the People's Republic of China (PRC), the land-based Silk Road Economic Belt (SREB) and the oceangoing Maritime Silk Road (MSR) (extracted from [Wiki Road]).

xii/XVIII Annex E – CIEG Components Explained9 The special regime (PRE) allows producers to deliver electricity to the network, through bilateral agreements with the Supplier of Last Resort (CUR), being subject to specific legislation, namely to promote the use of endogenous renewable resources, cogeneration or micro generation. With the publication of Decree-Law No. 215-A/2012, of 8 October, the PRE begins to integrate beside the production subject to special legal regime the entire generation of electricity from indigenous, renewable and non-renewable resources, even if not covered by a special legal regime, or even not having guaranteed remuneration, it can be remunerated by the market. The EDP Group is present in this segment through its subsidiaries EDP Gestão da Produção, S.A. and EDP Renováveis Portugal, S.A., among others.

Following the publication of Decree-Law 240/2004 of 27 December, which established the creation of a compensation mechanism to maintain the contractual balance (CMEC), in January 2005 the EDP Group signed the early termination of contracts for the Power Purchase Agreements (PPAs – although referred as CAE’s in the main document, its Portuguese equivalent) related to the binding electricity production plants of the EDP Group, effective as of 1 July 2007, date of the launch of the Iberian Electricity Market (MIBEL).

With the publication of Decree-Law 199/2007, of 18 May, the Portuguese Government confirmed its decision to early terminate the PPAs and implement the CMEC mechanism and defined the rules to calculate the compensations due to the power generators for such early termination, which essentially consisted in an adjustment of the reference market price of electricity used to calculate the CMEC initial compensation amount. On 15 June 2007, EDP and REN agreed on the early termination of the PPAs, effective as of 1 July 2007. The CMEC regulation sets the compensation due at 833,467 thousand Euros, which in accordance with the legislation can be subject to securitization.

In June 2007, Decree-Law 226-A/2007 of 31 May, which approves the new legal regime for using hydric resources under the terms of the new Water Law (Lei da Água), came into force. This Decree-Law in article 91, foresees the transfer of concession rights of public hydric resources of RTN to the companies holding the rights, and being subject to the payment of an economic and financial equilibrium value. The article 92 defines the calculation formula for the economic and financial equilibrium value, which was determined based on the value identified in two assessments conducted by highly reputed independent entities: Caixa - Banco de Investimento, S.A. and Credit Suisse First Boston. On that basis, the Government (INAG), REN and EDP Produção signed on 8 March 2008, several service concession arrangements related to the ex- SEP plants for which EDP Produção paid approximately 759 million Euros (corresponding to the contractual compensation following the Dispatch 16982/07) for the extension of the period to operate the public hydric domain for an additional average period of 26 years.

On 20 August 2012, the Administrative Order 251/2012 was published. This regulation replaces the previous mechanisms and establishes a new incentive scheme to energy generators. Capacity payments should contribute decisively and rationally to maintain the production capacity of electricity (availability incentive) and to perform future investment in new production capacity (investment

9 Extracted from EDP’s 2016 consolidated report

xiii/XVIII incentive), and therefore, to ensure security supply levels that are not guaranteed by the operation of the normal market mechanisms. The availability incentive is applicable to thermoelectric power plants until the end of the operating license, beginning in the calendar year following the date of termination of the PAF ("Programa de Apoio Financeiro"). This incentive corresponds to an annual compensation of 6,000 Euro/MW/year. Investment incentive is applicable to new hydroelectric power plants and power enhancement projects, during the first 10 years after the formal recognition of their eligibility to receive the incentive.

On 27 February 2013, the Administrative Order 85-A/2013 was published, approving the nominal tariff applicable to the tariff repercussion of the yearly fixed amount of the costs for maintenance of the Contractual Stability Compensation (CMEC), setting the rate at 4.72%. This rate is applicable between 1 January 2013 and 31 December 2027 and reflects a costs reduction for the system of approximately 13 million Euros per year, which corresponds to a present value of 120 million Euros. This adjustment results from the application of the calculating mechanism of the interest rate related with the fixed portion set out in Decree-Law 240/2004, of 27 December, amended by Decree-Law 32/2013, of 26 February (point iv) of paragraph b) n.4 of article 5.º).

The Portuguese Government published on 28 February 2013, the Decree Law 35/2013, that modifies the remuneration applicable to the production of electricity by mini hydro plants (PCH). Establishes that the PCH that were framed by a remuneration scheme prior to Decree Law 33-A/2005, of 16 February, benefit from that remuneration scheme for a period of 25 years from the grant date of the exploration license or until the expiration date of their water use license, whichever occurs first. After this 25-year period and as longer as the above-mentioned license remains valid, electricity produced by these plants will be sold at market prices.

Following the publication of Law 74/2013 of 4 June, which established a regulatory scheme in order to ensure the balance of competition in the wholesale electricity market, determining that the costs of general economic interest (CIEG) of the global use of the system tariff (UGS) should also be supported by the producers under the ordinary regime and other producers not included in the guaranteed return system, the Dispatch 12955-A/2013, of 10 October fixed the payment per MWh injected into the network, for each one of the power plants covered, in 3€ for on-peak hours and 2€ for off-peak, during the period from 11 October to 31 December 2013. Directive 26/2013 of 27 December, established the terms and conditions of the business relationship between those electricity producers covered by Decree Law 74/2013 and the operator of the transmission network.

xiv/XVIII Annex F – Guiding Case Questions

This annex separates the main questions that should be addressed in the proposed meeting by topic:

Strategy - What should be EDP’s next steps into the future? What kind of position should it assume before the Portuguese Government?

Finance - What is the weight of the CIEG on EDP’s results? How would these results be affected by a significant reduction of these subsidies? Were the subsidies too high to begin with?

Ethics – Should EDP assist the Portuguese Government in writing laws on energy?

Politics

1. Could the People’s Republic of China play a role in settling the ongoing talks around the Portuguese Government’s energy subsidies? 2. Regulation risk is one of the factors that is used in order to justify EDP’s investments and projections.. is there a risk of EDP losing its subsidies?

Marketing – Should EDP campaign to clear its good name, or would it be better to let the matter fall with the passing of time?

International Business Management – Discuss how EDP and CTG relate in terms of the management structures of International Business Management setups.

xv/XVIII Annex G - About the authors

João Carlos. M. Silva received the BSc and MSc degree for Aerospace Engineering from Instituto Superior Técnico (IST) – Lisbon Technical University, (1995-2000). From 2000-2002 he worked as a business consultant in strategic management in McKinsey&Company. From 2002 to 2006 he undertook his PhD in telecommunications at IST, integrated in 3 EU projects (Seacorn, B-Bone e C- Mobile), having been the representative of the university. Since 2006, he has been working on computer networks, as an assistant professor in Instituto Superior das Ciências do Trabalho e da Empresa (ISCTE). Recently, he finished his Masters on Business Management at ISEG (Instituto Superior de Economia e Gestão), and aims to work on technological management in the near future. Email: [email protected]

José Azevedo Pereira is a full Professor of Finance, at Universidade de Lisboa, ISEG - Instituto Superior de Economia e Gestão. He holds a PhD from the Manchester Business School and an MBA, from ISEG. Besides his academic career he has held top executive positions in several companies. During seven years he led the Portuguese Tax and Customs Authority, where he was Director-General and Chairman of the Board. Email: [email protected]

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References

(all website references were taken on January 2018)

[Observador 2016] http://observador.pt/2016/03/21/auditoria-confirma-subida-anormal-das- margens-centrais-da-edp-2012-2013/ [Observador 2017A] http://observador.pt/2017/06/02/contratos-de-venda-de-energia-o-que- querem-dizer-os-palavroes-cae-e-cmec/ [Observador 2017B] http://observador.pt/2017/06/06/rendas-barragens-e-suspeitas-as-explicacoes- dadas-por-mexia/ [Negócios 2013] http://www.jornaldenegocios.pt/empresas/energia/detalhe/ dez_perguntas_e_respostas_sobre_um_palavrao_chamado_cmec [Dinheiro 2016] https://www.dinheirovivo.pt/bolsa/edp-novas-metas-levam-analistas-subir-targets- das-acoes/ [Esquerda 2016] http://www.esquerda.net/artigo/quem-se-atreve-tocar-nas-rendas-da- energia/44295 [Dinheiro 2018] http://www.sabado.pt/dinheiro/oe2018/detalhe/oe2018-aprovado-geringonca- lado-a-lado-apesar-dos-ataques [Observador 2017C] http://observador.pt/2017/11/17/edp-leva-reguladora-energetica-a-tribunal- para-ter-acesso-ao-estudo-sobre-os-cmec/ [Observador 2017D] http://observador.pt/2017/11/04/edp-tera-feito-legislacao-dos-cmec- aprovada-pelo-governo-de-jose-socrates/ [Observador 2017E] http://observador.pt/2017/09/15/sp-tira-rating-de-portugal-de-lixo/ [Expresso 2017] http://expresso.sapo.pt/economia/2017-11-15-Concorrentes-da-EDP-comecaram-a- colapsar [Observador 2018] http://observador.pt/2018/01/05/edp-junta-se-a-galp-e-deixa-de-pagar-a- contribuicao-extraordinaria-sobre-a-energia/ [PLMJ 2014] https://www.plmj.com/xms/files/newsletters/2014/Janeiro/CONTRIBUICAO_- EXTRAORDINARIA-_SOBRE_O_SECTOR_ENERGETICO.pdf [JN 2017] http://www.jornaldenegocios.pt/empresas/detalhe/chineses-da-edp-procuram-sucessor- de-mexia [Wiki Road] https://en.wikipedia.org/wiki/One_Belt_One_Road_Initiative [Macauhub 2017] https://macauhub.com.mo/2017/06/20/pt-china-considera-portugal-parceiro- importante-na-iniciativa-faixa-e-rota-embaixador/ [DN 2011] https://www.dn.pt/economia/interior/edp-vendida-aos-chineses-por-27-mil-milhoes-de- euros-2201894.html [Expresso 2017] http://expresso.sapo.pt/economia/2017-10-03-China-Three-Gorges-reforca- posicao-na-EDP-pela-primeira-vez

xvii/XVIII [Damodaran 2014] Damodaran, Aswath: “The Global Landscape in Jan. 2015”, http//aswathdamodaran.blog.com.

[MIT 2003] Massachusetts Institute of Technology (2003). “The Future of Nuclear Power” .

[Khatib 2014] Khatib H.; “The Discount Rate – A Tool for Managing Risk in Energy Investments”, International Association for Energy Economies, 2014.

[Expresso 2017B] http://expresso.sapo.pt/economia/2017-12-10-Taxa-do-BE--para-as-eolicas-- ameaca-bancos

[Catroga 2017] Eduardo Catroga, Revista da Ordem dos Economistas, “Questões e Mitos no sector eléctrico”, December 2017

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